I understand the idea and math behind the concept of control variate for the sake of variance reduction, but I struggle to apply it to option pricing.

I need to simulate an European option of a stock which has the traditional charateristics:

  • $B(S_t) = max(S_t -K,0)$
  • The log-returns are normally distributed with parameters $(R-(\sigma^2/2))t$ and $\sigma_t$, with $R$ being the risk-free rate

I need to use a second European call option as control variate with strike $K_2$ and price $C_0$ which is assumed ot be close enough to the first option.

I need to give a algorithhm to simulate the price of the first option using the strike price and price.

I know that I need an high correlation to have an effective variance reduction and that the variance reduction can be computed as $Cov(X,Y)/Var(Y)$ but i don't see how to apply it in that context

  • 1
    $\begingroup$ Missing tag: homework? $\endgroup$ – LocalVolatility Jun 7 '18 at 14:39

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